171 



25 

py 1 



Business Economics 
and Statistics 



George R. Davies, A.M., Ph.D. 




sLAissmTin ragimnynn 



Lecture Text 



Business Economics 
and Statistics 

■ f By 

George R. Davies, A.M., Ph.D. 

Assistant Professor of Economics 
Charge of Instruction in Statistics 

Princeton University 




063(3. 

NEW York Philadelphia 



BUSINESS ECONOMICS AND STATISTICS 



but it has far-reaching practical applications. For unless we can answer 
it we have little power of forecasting costs and profits; and what is perhaps 
more important, we have no basis on which to judge what is normal and 
proper. 

To answer the question we will do well to try to see the market from 
the "enterpriser's" point of view. By the enterpriser is meant the one who 
assumes responsibility and risk in the handling of wealth. To be sure, the 
term is often little more than an abstraction, for so complicated is the business 
world that few men assume this function solely. In some degree every active 
person is an enterpriser selling his services, the uses of his capital, or his 
goods. He is investing what he has, and is taking the inevitable responsi- 
bility and risk. But in addition he is also performing other functions. Many 
men who are enterprisers on a large scale are also managers, and as we have 
just seen should properly charge off a certain portion of their income to their 
own time before reckoning what their capital has made. Perhaps in the 
director of a corporation we may find the function of the enterpriser in its 
most elementary form, particularly when he turns investigation and man- 
agement over to paid experts. And in any case we may conveniently per- 
sonify responsible control of business in the figure-head of the enterpriser, 
however much the function may in fact be divided. 

Let us assume the case of the enterpriser of a large industrial cor- 
poration. He is using his own and associates' property, borrowing funds, 
hiring labor, purchasing equipment and supplies, and placing goods on the 
market. Suppose for the sake of argument that business in general is pro- 
gressing fairly smoothly. Such change as occurs comes gradually, and is 
anticipated with some degree of accuracy. What now will determine the 
rent, interest, profits and wages that the enterpriser pays.^ 

The usual answer to this question is the law of supply and demand. 
This is quite correct, but it is too broad a generalization to be of much help. 
We must go further, and inquire into the conditions of supply and demand 
in each particular case. 



4 



BUSINESS ECONOMICS AND STATISTICS 



2. HOW THE INTEREST RATE IS DETERMINED 

Let us study, first, the interest rate. When the enterpriser floats 
bonds, or borrows at the bank for temporary purposes, what rate will he 
pay? The common answer is that the rate depends upon the amount of 
money in the country. But this answer is, in the main, wrong. It is one 
of the fallacies that practical men drop into by judging from a narrow 
view of the market. It is, of course, true that if a considerable volume of 
money comes rather suddenly into the banks the interest rate may tempor- 
arily fall. Such a case may occur when gold comes in from new discoveries, 
or when large volumes come in from abroad as in 1915 and 1916. The same 
effect may be produced when for any reason the banks feel safe in expanding 
their loans as compared with their reserves. Or, in times of dull business, 
it may occur simply because the money which usually actively circulates 
through the community is beginning to accumulate at the banks. But a 
low interest rate thus caused is transient. As soon as the money available 
for loans begins to be drawn upon, and the money and credit go into 
active circulation, prices begin to rise. Then larger loans are needed to 
carry business, and the rate rises. The quantity of money affects prices 
somewhat permanently, but it affects the interest rate only temporarily 
in the process of adjusting the price level. In 1920 the money in circulation 
per capita in the United States had increased sixty-six per cent over what it 
was in 1910, but the interest rates had risen rather than fallen. The change 
is shown in more detail in the following table, which shows also the tem- 
porary lowering of the interest rate that came with the gold importations 
from Europe in 1915 and 1916. 



BUSINESS ECONOMICS AND STATISTICS 



Table I. The Interest Rate in the United States 



YEAR 

1910 
1911 
1912 
1913 
1914 
1915 
1916 
1917 
1918 
1919 
1920 

There are, then, temporary fluctuations in the interest rate that are 
influenced by the quantity of money. If general prices are abnormally 
high or low, considering the available quantity of money, interest for a 
brief time will be correspondingly high or low. And high interest helps 
to bring prices down to normal, while low interest helps to spur them up, 
because interest influences the amount of bank credit which is used to sup- 
plement money. But aside from this matter of adjusting the price level, 
the real cause of the usual level of the interest rate remains to be discovered. 

Fortunately, we have not far to look. Any banker will say that in the 
long run an abundance of capital comes primarily from saving. This is 
no doubt the explanation of the interest rate as far as the supply of capital 
is concerned. Of course the amount that may be saved at a given time is 
limited. The greater part of most incomes is spent for necessities, and is 
therefore just as much invested as if it were put into bonds, since it serves 
to maintain the citizenship of a nation. But after all that may liberally 
be called necessities is paid for, there remains in modern times a large 



CIRCULATION 


INTEREST RATES 


PER CAPITA 


(prime 60-90 day paper) 


$34.33 


5.0% 


34.20 


4.0% 


34.34 


4.8% 


34.56 


5.7% 


34.35 


4.9% 


35.44 


3.4% 


39.29 


3.5% 


45.74 


4.8% 


50.81 


5.9% 


54.33 


5.4% 


57.09 


7.4% 



BUSINESS ECONOMICS AND STATISTICS 



surplus. This surplus may be insignificant among the poor, but it^aggre- 
gates a large amount among the middle classes and the well-to-do. The 
very rich may readily save and invest the larger part of their mcomes. 
If this surplus is lavished on more or less unnecessary pleasures and dissi- 
pations, business progress must come to a halt. If it is saved it goes to swell 
the volume of money and credit available for loans and— other things 
being equal— helps to keep down the interest rate. That is, the ease with 
which new capital may be obtained depends upon the general thrift. If 
everyone should religiously refrain from spending anything exceptmg for 
the necessities and charities that contribute to his own and the public 
efficiency, the maximum of thrift would be attained. 

Thrift, then, makes capital available. But this is, after all, merely 
one side of the question, and the negative one at that. Before anythmg 
can be saved it must be produced. Hence the inteUigence, energy and re- 
sources of a people are the real source of saving. So it happens that, wasteful 
as the American people are, they nevertheless save more than the 
thrifty populations abroad. We may at least congratulate ourselves upon 
our capacity for production, even while acknowledging our short-commgs 
in respect to thrift. 

From still another angle the capacity for production is highly important 
in its effect upon the interest rate. This is from the standpoint of the 
demand for capital. To see this, let us return to the enterpriser whose 
point of view we were endeavoring to hold. He and others like him are 
evidently one side of the loan market which determines the interest rate. 
The enterpriser voices the demand for capital, while the interest rate is set 
at the point of equilibrium between the demand and the supply. Now, 
what will determine how high a rate the enterpriser will be willmg to payr* 
If he is borrowing for a temporary need, he may perhaps pay an emergency 
rate which will impair his usual profits, but if this happens he wiU be likely 
to reduce his operations. Thus he will later be less of a factor in the market. 



BUSINESS ECONOMICS AND STATISTICS 



If others do the same as he, the high rate will come down for lack of bor- 
rowers. 

Or, we may suppose that the enterpriser is planning to sell long-time 
bonds in order to obtain funds for the permanent expansion of his plant. 
Before oJ0Fering the bonds he will sit down and figure out how much of a 
return on his increased investment he may expect. He will estimate whether 
the raw materials and labor which are required for the construction of the 
new buildings and machinery will result eventually in an adequate return. 
Will the venture pay expenses, depreciation, the interest on the bonds, 
and a reward for the time and effort of planning .^^ In making his calcula- 
tions he is directly or indirectly contrasting his own situation with that 
of other business men who are bidding against him for the use of the public's 
savings. If he thinks he can make enough to justify paying the rate that 
others are paying, he will borrow; that is, he will place his bonds on the 
market. The rate that he can make the money earn is therefore the deter- 
mining factor of demand in setting the general level of the interest rate. 

To summarize: The interest rate fluctuates temporarily with changes 
in the quantity of money and credit in circulation. But in a fundamental 
sense, the supply of capital is determined by effective thrift, while the 
demand is principally determined by what the enterpriser can make new 
capital earn in the expansion of his business. The interest rate at any given 
time is that which will approximately balance the supply and demand sides 
of the market. 

3. THE TOTAL EARNINGS OF CAPITAL 

Having stated the law of interest, we may now briefly turn to the 
two other forms of income going to capital; namely, rent and profits. 
It will easily be seen that both are of essentially the same nature as interest. 
In renting property a man expects to get enough to cover its upkeep and 
the trouble of looking after it, and in addition the usual rate of interest 
on its capital value. Hence rent expresses approximately an interest yield. 



BUSINESS ECONOMICS AND STATISTICS 



But just here the practical man often trips upon a Httle turn of logic 
that is very important in connection with the evaluation of property. Prop- 
erty has no intrinsic value apart from, its earnings, on which a rental may 
be figured. This is particularly true of land, though it is not so true of 
improvements that may readily be added or removed to other uses. The 
value of the property as a whole arises from the income that it will produce. 
If we are sure that a given piece of property will continue to net, say, a 
thousand dollars a year, then as an investor we might be willing to pay 
$20,000 for it. In so doing we would be making five per cent on our money. 
If there was considerable risk connected with the property that could not 
be readily written off as an insurance expense, then we would probably 
offer less in order to be assured of a higher rate of return on the investment. 
But if the risk was negligible and the usual interest ratje low, we might pay 
$25,000, which would give a yield of four per cent. On the other hand, 
if the property is likely to deteriorate, as a worked-out mine, a corresponding 
deduction from its capital value will naturally be made. Mathematically 
stated, the general rule is that the capitalized value of property is the 
present worth of the future net returns that are expected to arise from it. 

Practically the same rule applies to profits. In so far as the net earnings 
of a corporation can be anticipated, the value of the shares reflects the 
present worth of these earnings. The owner of the shares usually carries, 
however, more of the responsibility and risk of the business than the holder 
of the bond carries. Hence it requires on the average a somewhat higher 
rate of returns to attract him. But in well established corporations there 
often comes to be little real distinction between the ownership of shares and 
bonds. Both represent savings applied to the purchase of incomes. 

The problem that the enterpriser must meet, of whether he shall 
further expand his business, suggests another of the fundamental laws of 
economics. This is the law of diminishing returns. The term when first 
used was applied principally to agriculture. It was observed that when a 
farmer increased the amount of capital and labor applied to a given piece 



BUSINESS ECONOMICS AND STATISTICS 



of land, that the returns he got for his outlay gradually fell off. When 
he first doubled his outlay, it was possible that he might on the average 
double his crop. He might even do better, and get increasing returns. 
But if he doubled his outlay a second time, it was very unlikely that 
he would again double his crop. If he increased his outlay ten times, he 
certainly would not get a ten-fold crop. That is, his returns compared to 
his outlay would decrease. Later, it was seen that the same law applied 
in a general way to the profits arising from practically any business, or any 
industry as a whole. The industry that is expanded beyond the point 
warranted by the average growth of the country and the condition of the 
market sooner or later finds its profits dwindling. On the other hand, 
if it holds back too timidly, it may make a good rate of profits, but yet lose 
the volume it might have had. Thus the profits that lie just at the "margin '* 
of expansion — that is, which are next within reach — are the economic 
signposts pointing to the proper size for an industry. 

The law of diminishing returns operates in practically the same way 
for the individual business man or business unit as it does for a whole 
industry. An enterpriser must find the proper limit suitable to his capacity. 
He will lose either by undertaking too little or too much. Conditions will 
vary in different lines. The manufacturer of fine shoes, who must supervise 
much hand work, cannot profitably handle so large a plant as can the 
manufacturer of work-shoes, who uses machinery principally. By respond- 
ing to the law of diminishing returns, or of increasing returns as they may 
appear at first, businesses and industries grow into a certain relationship 
to each other, such that the public demand for goods is met in due pro- 
portions. 

A very practical side of the law of diminishing returns is seen in the 
application of statistics. By keeping a statistical check on the growth of 
various industries, the banks are able to estimate whether credit is being 
locally over-extended or not. The industries that have the most recklessly 



10 



BUSINESS ECONOMICS AND STATISTICS 

expanded under the spur of good times are just the ones that will be hit 
the hardest when a crisis comes. An adequate statistical knowledge will 
greatly lessen this danger, and will tend to keep businesses movmg together. 

The enterpriser, then, has various opportunities of investment into 
which he may turn the capital under his control. These opportunities tall 
under the two headings already discussed. First, he may expand his busi- 
ness temporarily or permanently. In so doing he anticipates a certam rate 
of profits on which he bases the interest rate which he will be willmg to pay. 
Naturally, capital devoted to expansion tends to be attracted mto the most 
profitable available channels. By the law of diminishing returns it there- 
fore tends to bring down the rate that may be earned on further expansion. 
On the other hand, new inventions and new avenues of foreign trade are 
continually opening up increasing returns. Secondly, if expansion is rela- 
tively uncompromising, the enterpriser may direct capital mto the buying 
of businesses already established and matured. In so doing he helps to 
drive up the price of these properties until the rate of yield on the invest- 
ment becomes unattractive. "Passive investment" of this sort apphes 
to the stocks and bonds of corporations, to speculation in commodities, 
and to real estate holdings great and small. Because capital can thus swing 
from the less promising to the more promising field, the interest, rent and 
profits rates tend to equalize, though in fact when business is active, m- 
equalities may be created more rapidly than they can be wiped out Ut 
course differences in risk are assumed to be allowed for. The average returns 
on all classes of capital is often spoken of as a prevailing interest rate. Like 
the sea level from which altitudes are measured, it is a useful figure ot speech, 
but hard to visualize. 

Before leaving the subject of the interest rate, one further question 
remains to be considered. Suppose that over a considerable period ot time 
the interest rate prevailing in one country is low, while m another remote 
country it is high. What does this contrast indicate? It is commonly said 
that it measures the thrift of the people. Low interest seems to indicate 



11 



BUSINESS ECONOMICS AND STATISTICS 



an abundant supply of capital, and high interest a scarcity. So the people 
where the low interest rate prevails are commended for their thrift, and the 
others are blamed for their sloth. Such a judgment might be merited, 
but it by no means necessarily is correct. The mere fact that interest is 
generally high or low gives us no basis for such a judgment. In a new 
country where the utmost possible economy rules, interest may be high 
simply because of the abundant profits that arise from expansion. The 
same may be said of an old country which is being rejuvenated by a series 
of profitable inventions. On the other hand, a slothful or luxurious people 
may suffer from a high interest rate because they refuse to save. Again, 
low interest may be due to lack of opportunity, or the timidity of enter- 
prisers, and may be accompanied with much luxury spending of the surplus 
incomes. Hence the interest rate taken alone is no index of the business 
character of a people. 

We have seen that the two general factors in production are capital 
and labor. Capital consists primarily of the land, and the buildings and 
equipment that have been accumulated upon it. It is expressed as a money 
value. This value depends upon the incomes that are anticipated from a 
specific property, and the prevailing interest rate. The term labor covers 
all valuable effort, from the planning of the manager and the research of 
the inventor, to the crudest forms of manual work. The value of labor is 
expressed in the market as a wage, using the term in the broad sense already 
indicated. The question of what determines wages in an open market will 
now be considered. 

4. WAGES AND THE WAGE LEVEL 

Like capital investment, labor finds many avenues open to it. The 
worker, seeking to invest his energies, naturally tends toward the more 
profitable market, insofar as his aptitudes, likings, and opportunities allow. 
But the movement of labor from one occupation to another is strictly 
limited by habit, and by the difficulties of mastering a new technique. 



12 



BUSINESS ECONOMICS AND STATISTICS 



So the process of equalizing wages in proportion to service is slow. In the 
professions it is gradually brought about by the influx of new recruits into 
the better paying fields. In the semi-skilled occupations, however, there 
is considerable shifting of labor from one line to another. In occupations 
of about the same grade, wages are thus approximately equalized. 

If all men had equal ability and opportunity, wages in all occupations 
would tend to an equality. Only minor features of agreeableness or dis- 
agreeableness would give a basis for any permanent difference. But in 
fact wages are naturally very unequal because of inherent differences in 
ability. Differences in opportunity also play a large part, but even if these 
were equalized, important wage contrasts would still be based on natural 
differences. Genius is extremely rare, talent is scarce, moderate capacity 
is abundant, while fortunately real incapacity is scarce. It is true that genius 
does not always bring its proper reward, because the market sometimes 
fails to appreciate it. But the talent of the professional classes commands 
a high return because it is both serviceable and scarce. 

Just as there is a prevailing interest rate, so there may be said to be 
a prevailing wage rate. This prevailing rate is most readily measured on 
the basis of common labor. But what is true of common labor, will under 
modern conditions generally be true of the higher grades of labor as well. 
Men rise from the lower to the higher ranks, and so moderate the extremes. 
If salaries are high, common wages will also be proportionately high. Thus 
the high managerial salaries in the United States are paralleled by the high 
rate for common labor. The level of common wages may therefore be 
taken as a base line by which to compare general wages in different countries, 
or at different times. 

The wage level is determined in somewhat the same way as the interest 
level. Enterprisers in operating and expanding their properties bid for 
labor. When business is active, they are likely to employ all who are employ- 
able, and to seek to obtain more by immigration. It is to their interest to 



13 



BUSINESS ECONOMICS AND STATISTICS 



keep practically all the labor force employed in order to attain maximum 
production and profits. But at times they may over-do their competitive 
bidding for labor, and send wages above their normal level. When this 
occurs, business becomes less profitable, and therefore slackens. Hence the 
volume of business will tend to conform closely to the limits of the labor 
force, though fluctuating above and below these limits. 

The size of the wage will evidently be limited by the productivity of 
labor. The economist would say the "marginal productivity," since it is 
the results obtained by adding to the labor force that serve as the practical 
measure of productivity. As long as enterprisers are able to make more 
than normal profits by adding to their labor force, they will be actively 
in the labor market. When an increase in the number of workers employed 
brings in no returns above the added wage cost, further employment will 
stop. At this point, more or less accurately estimated, equilibrium is 
reached. 

The demand for labor, then, expresses itself principally through the 
bidding of the enterpriser. His capacity for bidding is the productivity of 
his business. A country with rich natural resources, able enterprisers, 
and industrious and capable workers, will bid stronglj^ for labor. The supply 
of labor is the aggregate of services sold by the working population. This, 
in general, is proportionate to numbers. Wages are set by the usual equili- 
brium between demand and supply. This does not contradict the previous 
statement that the marginal productivity of the laborer sets the wage, 
since the marginal productivity responds to the supply in accordance with 
the law of diminishing returns, and is the basis of effective demand. 

Since supply and demand rule in the labor market, it is often thought 
that a considerable lessening of the labor supply will raise wages. This is 
not necessarily the case. It is true that a sudden shortage of labor may 
temporarily send up wages, but if the shortage is permanent, some busi- 
nesses will close and the labor demand will diminish. It is evident that an 
extremely sparse population in a fertile country is not favorable to high 
wages, since division of labor then becomes difficult. The immigration 



14 



BUSINESS ECONOMICS AND STATISTICS 



into America during the past century probably did not lower wages except 
locally and temporarily. On the contrary, it probably raised wages by 
making possible the diversified industries which now create the demand for 
labor. But after the point is past where the numbers of the population are 
suitably proportioned to the available resources, then further additions to 
the labor supply will lower wages. The former conditions give increasing 
returns; the latter decreasing returns. 

In view of the fact that population is continually increasing, the extreme 
importance of progress in business becomes evident. When adequate 
progress is maintained, enterprisers will have increasing incomes at their 
command with which to bid for labor. Using better machines and pro- 
cesses, labor will be more productive. Though some loss may be occasioned 
by the necessity of learning new methods of work, yet wages will be con- 
stantly rising. But if surplus wealth is squandered in luxurious living, 
new capital will be lacking, and progress may fail to keep abreast of popu- 
lation. Wages will then fall. 

More than a century ago a famous economist predicted that popula- 
tion would always increase so fast that wages would be driven down to the 
point of bare subsistence. Thus far his prediction has not proved true, 
nore does it seem likely to come true in the immediate future. It is true 
that population has increased with great rapidity during the past century, 
but production has increased still more rapidly. The estimates given in 
the following table show this fact for the United States during the past few 
decades. 

Table II. The Production of Wealth in the United States 



DECADE 

1870-1880 


population 

[millions] 

44 


production 
AT 1913 prices 

I billions of dollars] 

8 


PER CAPITA 
PRODUCTION 

{^180 


1880-1890 


56 


12 


210 


1890-1900 


69 


17 


240 


1900-1910 


84 


25 


295 


1910-1920 


100 


35 


350 



15 



BUSINESS ECONOMICS AND STATISTICS 



From this table it appears that per capita production or income, as 
measured in constant prices, has ahnost doubled in forty years, and is still 
increasing.* It may be shown that wages have increased about as rapidly, 
though not so evenly. In estimating wages, allowance must of course be 
made for price changes. This may be done by dividing an average of com- 
mon wages for any given year by the average of prices for the same year. 
Data are furnished by the Bureau of Labor Statistics from which such an 
estimate may be made. The results are called "real wages" to distinguish 
them from the wages as paid in current prices. For comparison it is found 
more convenient to express real wages in percentages of the year from 
which prices are reckoned. The base year now commonly chosen is 1913. 
Thus expressed, the index of real wages in the United States appears as fol- 
lows: 

Table III. Real Wages in the United States 

INDEX OF 
YEAR REAL WAGES 

1870 48 

1875 54 

1880 56 

1885 76 

1890 85 

1895 97 

1900 91 

1905 96 

1910 94 

1915 102 

These figures show that real wages rose very rapidly up to 1895, but 
that since then they have not advanced much. Some such results might 



* American industry probably leads the world in per capita production. Even before the war 
British incomes averages only about seventy per cent of American, and a certain part of that was from 
foreign investments. 



16 



BUSINESS ECONOMICS AND STATISTICS 



be expected, since by the end of the nineteenth century population had 
about caught up with the rapid industrial advance. The volume of capital 
used was greatly increasing, and land values were advancing as a result 
of the relative closing of the frontiers. But the slackening of advance in 
common wages is compensated for by the widening opportunities in the 
skilled occupations and the professions. 

The movement of wages and prices during and since the war is of 
interest, and is valuable as throwing light on the responsiveness of the 
labor market. It is often said that wages are stabilized by custom, and 
that therefore they move much more slowly than prices. This may have 
been very true in former days. It may also be true today of certain occu- 
pations, such as the postal service, teaching and preaching. But it is not 
so true of industrial wages, under present conditions. A considerable 
portion of the labor army is mobile, and quickly moves to the point of 
greatest demand. Union activities also tend to push wages up whenever 
the condition of the market makes it possible. Therefore the market for 
labor is coming to be almost as responsive as for commodities. At least, 
such is the conclusion that is suggested by a review of the figures for the last 
few years. The following table gives indexes for prices, and for labor 
of specified kinds. 

Table IV. Prices and Wages in the United States Since 1913 





WHOLESALE 


cost of 


WAGES 


HARVEST 


UNION RATE 


XEAR 


PRICES 


LIVING* 


(hour rates) 


HANDS 


(minimum) 


1913 


100 


100 


100 


100 


100 


1914 


100 


100 


102 


98 


102 


1915 


101 


101 


103 


99 


102 


1916 


124 


108 


111 


107 


106 


1917 


176 


133 


128 


131 


112 


1918 


196 


155 


162 


166 


130 


1919 


212 


184 


197* 


197 


148 


1920 


243 


212 


222* 


225 


189 



Annual indices estimated from seasonal data. Source, Bureau of Labor Statistics. 



17 



BUSINESS ECONOMICS AND STATISTICS 



Z80 
Z60 
ft4C 

180 
/60 

/40 
i20 

too 



/fj dices ofr/a^es anci CosT of Liy//f§^ /9/i-'/920 

jy/a^e<s, raU per /?our o 

Cost of liy//7^ X 

/m fp/s /m tm /m tgw 



f9Z0 



















■ 
























/ 












/ 


7^ 














— X •'^ 












y 


^-'^ 












/ 


<' 












^ 








O-ar 


^ 




.--^ 











/Monthly labor ffei^iety, ^eif., /92/ 
pp. 6/ and 74 



Figure'^1 



18 



BUSINESS ECONOMICS AND STATISTICS 



These data show that wages and the cost of living have moved approx- 
imately together. If real wages were to be computed, they would therefore 
show little change, except for a certain rise after the armistice. The move- 
ment of wages was not, however, nearly so uniform as averages make them 
appear. Some shot rapidly ahead and others lagged behind. Even in the 
same occupation, as farming, wide discrepancies appeared. But this scatter- 
ing was not confined to wages only, for it appeared also in price changes. 
In connection with price changes, both wholesale indices and retail cost of 
living indices are shown. This is done for comparison, since there was a 
prevalent erroneous use of wholesale figures in checking up the movement 
of wages. It is true that over considerable periods of time wholesale and 
retail prices follow much the same trend, but in a period of sudden change 
the latter lag behind. Since the annual indices for cost of living and in part 
for wages are estimates, the Bureau of Labor Statistics data as originally 
published are presented in graphic form. (Figure 1.) 

In the foregoing discussion we have considered labor as a commodity. 
This is not meant to imply that the human side of the labor problem is 
forgotten. But when we are speaking of what determines wages in a labor 
market, we are necessarily obliged to concentrate upon factors of supply 
and demand. That human beings embodying the labor power which is 
bought and sold have rights to considerate treatment, goes without saying. 
The common protest against classing labor merely as a commodity is justi- 
fied. The same point should in fairness also be made regarding capital. 
Though capital is based upon material things, yet back of it are human 
rights of leadership, management, and dependency that must be taken into 
account when legislation is contemplated. 

5. VALUE AND PRICES 

Wages and the returns to capital (except perhaps a margin of excess 
and final profits) make up the cost of production. This cost appears norm- 
ally in the prices of the goods sold on the market. It is therefore usually 



19 



BUSINESS ECONOMICS AND STATISTICS 



said that cost of production is the proper basis on which prices are estab- 
lished. This is only partially true, for the rule works both ways. The price 
of wheat land, for example, depends on the fact that the public demands 
white bread. The price that the public will pay for such bread is therefore a 
big factor in determining the cost of production. This consideration will 
serve to introduce the difficult problem of value. 

To think clearly regarding value we must first adopt the abstract idea 
of considering people in dual capacities. Practically all persons are both 
producers and consumers. But, for convenience, we are obliged to think 
of consumers as if they were a different class set over against producers. 
Since the majority of people produce directly for other persons rather than 
for themselves, this figure of speech is allowable. 

Consumers have certain more or less definite requirements determined 
by various combinations of such forces as: nature, instinct, custom, income, 
suggestion, fashion, and whim. They look upon certain goods, therefore, 
as having utility. Sometimes this utility is real, as in the case of food; 
sometimes it is imagined, as in the case of curios; but whether real or 
imagined it is a force in determining prevailing values. If the desired goods 
can be had with little or no trouble, value may be next to nothing, though 
the utility is high. Such is the case with water and air. But if the desirable 
goods take labor and material to produce them, their value rises. If, again, 
they depend on land that is scarce, as precious metals, demand will drive 
up the value of the land, and the goods will be correspondingly valuable. 

Between the price that people are willing to pay, and the diflSculty 
of obtaining the goods, an equilibrium tends to be established. If people 
decide to use more of a certain thing, and are willing to pay the price, pro- 
duction spreads over to less advantageous lands and means, and the cost 
of production rises. If they decide to use less, capital and labor retreat 
to the more advantageous sources, and cost of production falls. At the 
price thus set, each consumer uses such quantities as may be appropriate 



^0 



BUSINESS ECONOMICS AND STATISTICS 



in view of the diminishing utility to him. Diminishing utility is, of course, 
merely a personal phase of the law of diminishing returns. To a person of 
moderate means, a hundred dollars expended in a given season for hats 
will not bring ten times the satisfaction that a ten-dollar expenditure would 
bring. The thoughtful consumer naturally tries to apportion his income 
over the various categories of food, clothing, housing, recreation, and mis- 
cellanies in such a way as to get the best balanced returns for his money. 

We must now recall the fact that producers and consumers are really 
the same set of persons. What they make as producers, they spend as 
consumers and investors. Therefore in the aggregate, supply and demand 
are necessarily equal. 

There are, of cours,e, certain ideal values (or social values) that would 
develop in the market if all persons were perfectly wise and virtuous. Such 
a market would measure the real exchange values of goods. But frail 
humanity doubtless often appraises dross as gold, while real quality goes 
without a bidder. Hence real values and current values are by no means 
identical. But the economist must study things as he finds them, so when 
utilities and values are mentioned, the current estimate is assumed to be 
valid. 

Value is measured in terms of price. Price is the actual exchange 
ratio between goods and money. If coal sells at ten dollars a ton, this means 
that a unit of coal is approximately equal in value to ten units of money. 
As we have seen, the value of the coal depends upon its utility, the scarcity 
of good coal lands, and the capital and labor needed to mine and transport 
it. Some people would charge a part of the price to profiteering. Be that 
as it may, the coal in the market is equated with the price that it brings. 

Next, what determines the value of money? We find that in business 
payments may be made with credit (bank checks and paper money), with 
light-weight minor coins, or with gold. In any case the last is the basis on 



21 



BUSINESS ECONOMICS AND STATISTICS 




/850 



'40 'SO %0 '70 '80 '90 1900 '/O 

l/Vho/esa/e Prices in the Unifecf 5tafes, im-l9Z0 



'20 



Figure 2 



BUSINESS ECONOMICS AND STATISTICS 



which the payments, through possible exchange, rest. A dollar in reality 
is 23.22 grains of pure gold. And evidently the value of the gold is deter- 
mined in practically the same way as coal. The only essential difference 
is that the gold miner must sell in a constant market, since the price of his 
product is fixed at the mint. 

Since money rests on gold, as is the case under the gold standard, we 
might expect that when a Klondike is opened, or when improved methods of 
extracting the metal are put into use, money would tend to become cheaper. 
This is not meant to refer to the interest rate, which has already been treated, 
but to the exchange value of gold. Since the gold would be obtained more 
easily, its value should under such conditions be less. Conversely, when 
mines play out, or when the growth of business has greatly stressed the 
demand for gold, we might expect the value of money to rise. This is, 
in fact, the case. But, it will be asked, how can a dollar vary in value 
when its price is fixed by law at the mint? Is not a dolar always worth 
just a dollar? The answer is that the value of money is measured by what 
it will buy. When prices double, as they have in the last few years, the 
dollar is worth half as much, because it will buy only half as much. 

The fundamental explanation, then, of the price level lies in the relation 
between goods in general and the standard money. If both increase or 
decrease together, prices tend to remain steady. But if one becomes rela- 
tively more abundant, its value falls, and the value of the other rises. So, 
great increases in gold have brought rising prices; while periods of steady 
improvement in the production from factory and farm, have brought falling 
prices. The rising prices from 1896 to 1914 are an example of the former 
condition, and the falling prices from 1878 to 1896 are an example of the 
latter. (Figure 2.) 

In order fully to explain the changes in general prices, we must turn 
to other factors that modify the price level. The most important is the use 
of credit as a form of, or a substitute for, money. Credit may be utilized 



23 



BUSINESS ECONOMICS AND STATISTICS 



in the form of paper money issued by the government. Such money may 
be given an initial value by being made redeemable in gold, or simply by 
being receivable for taxes and by being declared legal tender. When such 
money is put into circulation in large quantities, the value of the circulating 
medium falls, and goods rise. Even though the public may have full con- 
fidence in their government, the value of the money will decline simply 
from the fact of its abundance. Or, to put it another way, abundant money 
bids up the prices of goods. 

But prices thus inflated will cause the standard coins to disappear. 
This will occur at first through international trade. High prices attract 
goods from abroad, and gold goes out in settlement of the adverse balance 
of trade. But even apart from such exchange, gold will disappear because 
of an increased use as jewelry and other articles. For such articles tend to 
rise with other prices. Then an increased profit accrues to the goldsmith, 
since as long as the gold standard is in force he can get his raw material at 
a fixed cost merely by melting standard coins. Hence he puts an abundant 
supply on the market, and pushes his sales or lowers his prices, as he can well 
afford to do. On the other hand, the gold miner finds his business unprofit- 
able, since he must pay more for labor and materials, and yet sell at a fixed 
price. Gold production therefore falls off. Thus the paper money gradually 
displaces the gold. 

But if the issue of paper money is not excessive, the rise in price is 
largely relieved as the gold disappears from circulation. Things may then 
settle down on the basis of a currency consisting principally of paper. As 
long as a safe margin of gold remains, the use of credit money is commend- 
able as an economy. 

If business is conducted for some time on the basis of a currency con- 
sisting largely of paper, and this currency is suddenly contracted, results 
exactly the reverse of those just described will appear. Money, being 
scarce, rises in value. Prices consequently fall. Low prices attract foreign 



24 



BUSINESS ECONOMICS AND STATISTICS 



buyers, and gold comes into the country. The production of jewehy falls 
off, since its price declines, while the principal element in its cost remains 
fixed. Gold producers thrive on low costs, and their output increases. 
Consequently the gold available for circulation gradually increases. 

From the foregoing description of the inflation and deflation of a gold 
currency by the use of paper, the adjustment between the value of gold 
and the price level may be understood. But as a rule the buffer between 
the standard money and goods is not political money, but bank credit. 
When commercial banks have a surplus of gold or other legal reserves, they 
lower their interest rate and make loans on properly secured business paper. 
The loans are entered on the books, and are transferred by check. They are 
therefore often called "deposit currency." In such transactions the banks 
are in effect putting into circulation the private notes of business men, 
backed by their own credit. In a more formal way the Federal Reserve 
banks make business paper the basis of their own circulating notes, adding 
for security an adequate gold reserve. It is evident that "deposit cur- 
rency" will have the same effect: on prices as Federal Reserve notes or green- 
backs. When the quantity increases, money cheapens and prices rise. 
As prices rise, more money is needed in circulation outside of the banks, 
and the demand for loans becomes greater. Eventually gold begins to be 
drained away just as in the case of the issuance of paper money already 
described. Then the bankers raise the interest rate, and advocate the 
liquidation of loans and the contraction of business to safe limits.* As 
bank credit is contracted through liquidation, prices fall. Thus an equili- 
brium between the value of gold and the average value of goods tends, 
with many fluctuations, to be maintained. 

A final factor to be noted is largely psychological. This is the rate of 
circulation. If business becomes very brisk, money and credit are circu- 
lated rapidly. This has much the same effect as increasing the quantity, 

* Temporary relief is often obtained by the use of capital from abroad, which is attracted by high 
interest. But this merely diffuses the strain of inflation, and does not cure it. 



25 



BUSINESS ECONOMICS AND STATISTICS 



since each unit transacts more business. Hence when people are optimistict 
and lavish in their expenditures, prices are driven up somewhat, simply 
as a result of this factor. But when reserves are running low, and when 
high interest on bank loans is threatening profits, a spirit of pessimism checks 
the rate of spending. Perhaps the public then suddenly becomes economical, 
as was the case in the crisis of 1920. This is spoken of as a consumers' 
strike. Such a reaction naturally follows a period of over-activity and extra- 
vagance. 

The chief factors directly determining the price level are often expressed 
in the following formula: P = MR-^N. This means that prices (P) vary 
directly as the circulating medium (M) and the rate of currency circulation 
(R), and inversely as the number of physical units of goods (N) transferred 
in the aggregate of trade. MR really means the total sales during the period 
in question, in dollars at actual prices. N is equivalent to the value of the 
same goods at average prices, or at the prices of some year chosen as a base. 
The one divided by the other will evidently give the percentage of the cur- 
rent prices to those taken as the standard. The formula is useful as a 
basis for understanding price movements, but of course it does not explain 
why at certain times production or circulation increase, or why the rate is 
unsteady. In applying the formula, indices are used rather than absolute 
numbers. It is difficult to get any statistical measure of the number of 
goods traded, but this naturally varies more or less closely with production. 
Hence an index of physical production is substituted for N. Consequently 
the increases in the circulation of money and in the exchanges of goods 
that are due merely to speculation cancel out, and R stands for changes in 
the activity of buying for use. 

The following table gives indices based on estimates of the values enter- 
ing into the equation of exchange for the past eight years. In arriving 
at the value of M, bank deposits subject to check are given double the 
importance of actual money, since they circulate at about twice the rate of 
the latter. For much of the data used, indebtedness is acknowledged to 



26 



BUSINESS ECONOMICS AND STATISTICS 



Professor Kemmerer's "High Prices and Deflation." The value of R is 
computed from the other factors. It should conform to the known changes 
in business activity, as apparently it does. 

Table V. The Equation of Exchange, 1913-1920 
Indices of: 



year 

1913 
1914 
1915 
1916 
1917 
1918 
1919 
1920 

One further fact may be noted regarding the relation of money and 
credit to prices. If credit in the form of paper money or bank loans is greatly 
increased, we have seen that the gold reserves tend to disappear, and defla- 
tion is made necessary. But suppose a country should hoard the gold 
reserves in the central banks and refuse to pay out coin for paper, while 
at the same time continually increasing the issues of paper. Such an action 
would send the paper money to a discount, that is, gold would be at a 
premium. The connection between the paper and the gold currency would 
be broken and prices in terms of the paper would soar, though in terms of 
gold they might not change greatly. This is what usually happens in times 
of war. At such times, also, prices may be still further heightened by a 
scarcity of goods. Most of the currencies of Europe are at present virtually 
on a paper basis, in spite of the hoarded gold which is held as reserves 
against the credit currency. The same thing happened in the United States 



27 



holesale 


CIRCULATING 


RATE OF 


physical 


;PRICE8 


MEDIUM 


CIRCULATION 


PRODUCTION 


p 


MX 


R 


N 


100 


100 


100 


100 


100 


105 


94 


99 


101 


112 


96 


106 


124 


137 


101 


112 


176 


167 


121 


115 


196 


186 


120 


114 


212 


215 


104 


105 


243 


230 


117 


111 



BUSINESS ECONOMICS AND STATISTICS 



during the Civil War, but not during the recent war. However, the great 
gold importations of 1915 and 1916, together with the expansion of bank 
credit made possible by the newly established Federal Reserve system, 
had the effect of sending prices up about as high as the former greenback 
prices. But the gold standard was nominally preserved, except for a tem- 
porary restriction for a couple of years in the way of a gold embargo. 

We may now observe briefly the application of the foregoing principles 
to the activity of the general market and the course of prices. 

6. BUSINESS CYCLES 

Business moves in irregular cycles. This may be illustrated by the 
figures just given (Table V) showing the course of business since 1913. 
The depression of 1921 may be compared with its parallel in 1914. The war 
stimulated business, and an early crest of the wave appeared in 1917 and 
1918. The armistice brought a brief downward movement, which is re- 
flected in the production and rate of monetary circulation of 1919. But the 
latter part of that year saw easy money and a continuance of prosperity. 
The climax was reached about May, 1920. High interest and a consumers' 
strike precipitated a rapid downward movement, as drastic as anything 
that may be found in our history. Only the resources of the Federal Reserve 
system prevented a disastrous panic. The painful process of readjustment 
of all phases of business followed. Capital values, prices, and wages are 
being re-established on a level nearer to what is warranted by the supply 
of sound money. 

Looked at in the large, business cycles are found to be influenced by 
cycles in climatic conditions, which affect the crops. But this connection 
is too remote to be of much practical value in judging the market. It may 
be said, though, that good crops act as a gradual promoter of business 
prosperity, though the effects may be delayed. The business cycle is far 
more directly related to the inflation and deflation process already described 
than to anything else. 



BUSINESS ECONOMICS AND STATISTICS 



What, then, are the signs by which the changing phases of the business 
cycle may be known? A number of reliable barometers, so-called, are in 
general use. The central phase of the cycle, the actual productive activity 
of business, may be measured by large bank clearings, output of iron, build- 
ing permits, railroad gross earnings, imports, or other data. Of course 
price movements are also excellent indicators. These may be measured by 
several popular indexes, such as Bradstreet's and Dun's. The Bureau of 
Labor Statistics index is probably better than either of these, but it does not 
appear so promptly. In a general way, all these factors rise and fall together 
like a great tidal wave, though exceptional conditions may cause them to 
vary. In most cases something must be allowed for seasonal variations. 
Thus railroad gross earnings regularly rise at harvest time and fall in the 
winter. But allowing for this, the longer movements of the cycle may 
still be seen. 

Predictions of coming changes in the cycle may best be read from 
data on speculation and banking. The percentage of reserves held by the 
Federal Reserve banks is perhaps today the central indicator. Though 
the policy of the Board may temporarily modify the situation, yet if re- 
serves are steadily rising, sooner or later the interest rate will fall. This will 
stimulate business, but the first effects will commonly be observed in specu- 
lative activities. Thus the trend of business on the New York Stock Ex- 
change is one of the best business forecasters. A steady rise in stocks after 
a period of depression will herald business activities some six months or 
so in advance. Similarly, a general decline in the stocks will herald a 
depression. 

As the business cycle waxes toward its climax, the interest rate will 
be observed to rise, for reasons already explained. This measures the strain 
that is being thrown upon the banks. As the strain grows, the break in 
business and prices approaches. By watching the various barometers as 
they are reported in the financial journals, one may catch the early signs 
of the change. The details of personal business may then be adjusted 
accordingly. 



29 



BUSINESS ECONOMICS AND STATISTICS 



7. CONCLUSION 

In conclusion a word may be said regarding the modern tendency 
toward large scale consolidation. Such organization brings marked advan- 
tages, which must be tried out and limited by the law of diminishing returns. 
But at the same time they bring a danger of monopoly. It is likely that 
consolidations and organizations of v)a-rious sorts will increase rather than 
decrease. Doubtless ways will be found of securing the advantages of such 
co-operation, while at the same time eliminating the monopolistic elements. 
In any case, whatever direction business evolution may take, we may be 
sure that we shall have need of an ever widening knowledge of economic law. 



30 



